Creditors Must Learn To Take Losses: Goldman Economist

Austerity measures put in place by peripheral euro zone countries will eventually bear fruit, but going forward bond investors will have to start getting used to taking losses on their principal, Erik Nielsen, the Chief European Economist at Goldman Sachs, told CNBC Friday.

"At the most fundamental level, we have to return to a state in which both shareholders and creditors can lose their money if their investments go wrong, and senior debt will therefore have to be included in future debt work-outs wherever possible," Nielsen said.

The euro zone debt crisis' end-game could take 10 years to play out and "will be one of policy adjustments along with further adjustments of the framework for policy coordination," he added.

"The EU Summit in December agreed on the establishment of a permanent rescue mechanism, and while the details have yet to be worked out, we think it will resemble the IMF in terms of lending facilities against policy conditionality," Nielsen pointed out.

He dismissed the idea of anyone leaving the euro on the grounds that the cost of doing so would simply be too high and said the markets will return to focusing on fundamentals.

"When exactly markets will calm down is difficult to say because, ultimately, this is a confidence game. However, it seems unrealistic to think that it will all calm down in early 2011 given the substantial funding needs hitting the market the next few months," he said.

Permanent Mechanism

George Osborne, the UK Chancellor told CNBC on Thursday that the last thing the euro zone needs is another year of waiting for different countries to have different problems.

“In the next couple of months we need to see the permanent mechanism in place agreed on and that needs to underpin confidence in the euro zone,” said Osborne as he met European finance ministers in Paris.

“Individual countries need to take action domestically where they have high budget deficits; as I think Britain has demonstrated, you can put forward deficit reduction plans that earn market credibility,” he added.

This has so far been the case for the UK but as the euro zone crisis swept across bond markets in 2010 this was certainly not the case for Ireland or Greece, who imposed huge austerity measures, had to seek assistance from the ECB, EU and IMF and are still paying over 9 percent and 12 percent respectively to borrow.

Despite assurances from the ECB, German government and others that markets should not underestimate the political will to keep the euro zone project alive, investors remain worried.

The uncertainty caused by the sovereign crisis is in part about fears over the health of the banks, according to Nielsen, who does not think it is realistic for smaller euro zone nations to take full responsibility for recapitalizing their banks if problems arise.

The EU should take on part of this job, but there is no mechanism in place, he said.